European international central securities depositories (ICSDs) have coped well with pandemic-related market volatility thanks to ample latency in transaction systems, strong risk-control frameworks and limited exposure to short-term collateralised credit risk, Fitch Ratings says. ICSDs remain exposed to extreme external events such as the temporary closure of trading venues or the default of a large trading bank, but Fitch views such events as tail or event risks that do not drive ICSDs’ ratings.
Belgium-domiciled Euroclear Bank (EB; AA+/Stable) and Luxembourg-based Clearstream Banking SA (CBSA; AA/Stable) are Europe’s two ICSDs, and offer settlement, custody and collateral-management services for international fixed-income securities. Both entities are part of wider financial market infrastructure (FMI) groups. EB is the ICSD of the Euroclear group, which also has domestic CSDs in France, the UK, Ireland, Sweden, Finland and Benelux. CBSA is part of the Deutsche Boerse group, which includes the German stock exchange, the German CSD and Eurex Clearing; one of Europe’s largest clearing houses.
The first impact of market volatility (since early March) on ICSDs has been a sharp increase in settlement transaction volumes, which should ultimately support the profitability of ICSDs. For example, CBSA reported a 61% yoy increase in the number of transactions in March. Volumes of securities deposits and securities financing have also increased, by 3% yoy and 15% yoy respectively. First-quarter net revenue for Deutsche Boerse’s Clearstream segment (which includes the German domestic CSD) increased by 13% yoy. Transaction volumes for the remainder of 2020 are difficult to predict but, alongside profitability, they have held up well during previous periods of market volatility, including the 2008 global financial crisis.
The revenue of ICSDs primarily relates to net fee income from assets under custody, settlement transactions, securities lending and collateral management, which together typically account for around two thirds of revenue. Net interest income (relating to short-term collateral placements by generally highly-rated banks, and accruing to the ICSDs) accounts for much of the remainder. As a result, Fitch believes that ICSDs’ earnings and profitability will not be affected by those factors that will affect commercial banks, such as increasing impairment charges or reduced lending volumes. However, net interest income will come under pressure from lower base rates.
The sharp increase in transaction volumes also strains ICSDs’ operational capabilities. However, ICSDs have made considerable investment in their operating and risk infrastructure, reflecting their role as FMIs. As a result, ICSDs have generally coped well with pandemic-related higher transaction volumes and remote working practices, and have had to implement only minor changes to their processes.
Operational infrastructure (including infrastructure provided by external suppliers) is designed to absorb sharp increases in transaction or settlement volumes as well as to deal with IT outages, the default of major counterparties or cyber-attacks. Liquidity risk from failed settlement activities, which could be material, is mitigated by large liquidity buffers (both on-balance-sheet and contingent liquidity) and a regulatory requirement that ICSDs’ liquidity must be able to withstand the simultaneous default of their two largest counterparties, as stated by the Central Securities Depositories Regulation (CSDR).
The credit risk exposures of ICSDs are materially lower than those of most other financial institutions, reflecting the overall risk appetite of ICSDs and recent regulatory developments, notably in the CSDR. Moderate credit risk largely relates to intraday collateralised credit facilities that are granted to generally highly-rated banks, investments in debt securities (mostly of sovereign and supranational entities), and secured securities lending transactions. As a result, the exposure of ICSDs to pandemic-related impairment charges is in our view materially lower than that of financial institutions with meaningful lending activities. Unsecured credit exposure is essentially limited to sovereign or quasi-sovereign counterparties due to provisions in the CSDR.
The exposure of ICSDs to a potential deterioration in European sovereign credit profiles is in our view materially less pronounced than for most other financial institutions. The credit profiles of FMIs are partly countercyclical to the credit profile of the respective sovereign, as there may be increased trading activity during periods of stress.
Neither EB nor CBSA has significant exposure to its country of domicile. Similarly, and unlike commercial Belgian banks, EB’s direct exposure to Belgian sovereign risk is limited, accounting for about 13% of its equity at end-March 2020. EB’s ratings were therefore unaffected by Fitch’s recent rating action on its sovereign, Belgium (AA-/Negative), because Fitch believes that EB remains very resilient in a sovereign stress scenario.
Fitch typically constrains commercial bank ratings at no more than two notches above that of the sovereign under its “Bank Rating Criteria”, but exceptionally strong specialist banks such as EB can achieve a rating that is more than two notches above that of the sovereign. A downgrade of the Belgian sovereign rating into the ‘A’ category would not immediately trigger a downgrade of EB’s Long-Term Issuer Default Rating (as reflected in its Stable Outlook), assuming that EB’s direct exposure to Belgian sovereign risk remains low.
The ratings of both EB and CSBA remain sensitive to factors outlined in the most recent rating action commentary (see “Fitch Affirms Clearstream Banking and Euroclear Bank; Outlooks Stable'”, dated 29 August 2019). These include exposure to significant operational risk events (in particular in light of their fairly moderate capital bases in absolute terms), a sustained fall in revenue due to adverse reputational developments, an inability to adapt to regulatory change, weakening capitalisation and higher risk appetite.